Why India's start-up sector is facing a 'funding winter' in 2022

Global economic uncertainty and investors asking tougher questions about valuations has led to an outflow of capital from emerging markets

Digital payments company Paytm joined a wave of big name start-ups that listed on stock markets in India last year. Reuters

Investment in India's start-up sector has entered a “funding winter” following a record year in 2021, amid the global economic uncertainty and cautious investors asking tougher questions about the path to profitability and valuations.

“There is a clear impact of the funding winter across the world, and start-ups were unable to raise a lot of capital,” says Gaurav VK Singhvi, co-founder of angel investor network We Founder Circle.

“Indian start-ups are also feeling the winter impact.”

It was a landmark year for start-ups in India in 2021, with the booming sector attracting a record high of $38 billion in investments.

Major global investors including Softbank, Tiger Global and Sequoia Capital wrote big cheques for well-established start-ups, according to Tracxn, a start-up data platform.

________________

Watch: Modi says India aims to become developed nation in 25 years

The coronavirus pandemic and working from home trend accelerated the rapid growth of India's digital sector, helping to fuel investor interest.

Last year, 44 start-ups in India became “unicorns”, the term for new ventures with a value of more than $1bn.

This year, however, many start-ups are finding it much tougher to raise funds, amid factors that include Russia's invasion of Ukraine and the US Federal Reserve increasing interest rates, which has led to an outflow of capital from emerging markets.

In the first eight months of this year, Indian start-ups raised $20.82bn in funding, down 17 per cent from the $25.3bn they attracted during the same period in 2021, according to data from Inc42.

The Inc42 data also shows a slowdown in recent months compared with the first half of the year.

However, the number of deals, was higher this year: 1,129 compared with 948 during the first eight months of 2021, the data shows, suggesting that investors are injecting smaller amounts into start-ups.

The lack of investment has led to 41 of India's later-stage start-ups laying off 12,526 employees this year, according to Inc42's figures.

“In response to a correction in the world's financial markets and the continuing funding winter, venture capital funding for later-stage Indian start-ups is slowing down starting in the second quarter of 2022,” says Prateek Toshniwal, a wealth manager, investor and leadership coach.

“Investors are becoming more cautious and placing smaller-sized, longer-term bets on early stage start-ups.”

But it is not only global factors that are holding back investment in start-ups.

A wave of big name start-ups listed on stock markets in India last year, including digital payments company Paytm, online insurance comparison platform PolicyBazaar, and fashion and beauty e-commerce company Nykaa.

All of these stocks are down sharply on their listing prices, as investors question their lofty valuations.

“I think the public market performance of the so-called 'darling' IPOs has provided a little bit of sobering reality to venture capitalists; that at the end of the day, the public markets are not going to save your extremely high valuation,” says Barnik Maitra, managing partner at international consultancy Arthur D Little, India.

However, this year is still “a reasonably healthy year for investments into start-ups in India”, compared with a very high base in 2022, Mr Maitra says.

“Actually, more start-ups are getting funded. But the VCs are a little bit more cautious on the cheque sizes. They're actually writing smaller cheque sizes going earlier into the cycle and doing far fewer mega deals.”

The smaller funding rounds have led to some much-needed rationalisation in the sector, Mr Maitra says.

“What's going on right now in the Indian start-up ecosystem, to me, is a net positive, because all VCs were not quite comfortable with the inflated valuations and the lack of focus on unit economics and profitability.”

This means it is harder for start-ups to raise large rounds of funding and valuations are being positioned at lower levels, which could challenge the survival of some companies.

But early stage start-ups with good business models are in a strong position to raise capital and there is a trend towards companies that are more careful with their spending, and where there is a clear path to profitability, experts say.

This bodes well for future and sustainable growth, says Mr Singhvi.

“The silver lining is that Indian start-ups are now working towards building a profitable business,” he says.

“Earlier, the start-ups focused on customer acquisition and profits took a back seat. That is changing dramatically and it's a definite positive sign for start-up companies in the coming year.”

Next year looks very promising because of consolidation and as the valuation of start-ups becomes more rational, which has already created some good opportunities for investors, Mr Singhvi says.

“We are getting opportunities. So far, We Founder Circle has invested in 40 companies. The signs are positive — many start-ups are coming in for funding, better valuations. From our perspective, it is a good year.”

Electric vehicles is one sector in which We Found Circle is particularly bullish, he says. Other sectors of interest include health technology and agriculture technology ventures.

“These are the sectors that are upcoming and we are focusing on them,” Mr Singhvi says.

While We Founder Circle is less than two years old, it has deployed double the capital in the first nine months of this year compared with last year, and its investor base has increased to 5,400, he says.

Start-ups in sectors such as cryptocurrency and gaming, which were popular a year or two ago, have fallen out of favour among investors due to regulatory concerns, industry insiders say.

The funding environment has “dampened compared to last year”, says Mugdha Pradhan, chief executive and founder of iThrive, a Pune-based health start-up that raised $350,000 in a pre-series A round in November and is now trying to raise its next round of funding.

“We think it's the market correcting itself. But good businesses with a focus on bottom lines are seeing interest.”

Amrit Singh, co-founder of Indian HeathTech start-up Loop Health, agrees, saying: “Generally, fund-raising is really difficult right now.”

However, he says: “We've had lots of inbound interest from growth stage funds. This goes against the narrative seen for other start-ups who are having lots of trouble raising money this year.”

Many venture capital firms are sitting on funds they have raised, known as “dry powder”, and are ready to deploy when presented with the right opportunity, industry experts say.

“Companies with good fundamentals will not have a dearth of investment,” says Meghna Agarwal, an angel investor and co-founder of co-working space start-up IndiQube.

“Founders who are in the business of running companies and not in the business of fund-raising will surely not have a problem.”

Despite the challenging environment, Mumbai-based early stage fund Unicorn India Ventures says it has not slowed down on its deployment of capital this year, and has invested more this year compared with a year earlier, as it capitalises on the correction in valuations of start-ups.

“Of course there has been correction on enterprise value, which was much anticipated but the interest in investing in start-ups is intact and growing strong with each passing day,” says Anil Joshi, managing partner at Unicorn India Ventures.

“The investment pattern for Unicorn India Ventures has been more or less the same this year. On an average we invest in six new companies every year plus a couple of follow-on rounds in existing portfolios. This year we have already invested in six companies so far and a few follow-ons.”

So far this year, the fund has invested in a number of start-ups, including one that offers a battery management system for electric vehicles, another that focuses on smart vending machines and a neobank for foreign remittances.

However, there may be some early signs of a thaw in the funding winter, according to figures by GlobalData.

In August, 128 Indian start-ups managed to raise a total of $995.1m, up 9.7 per cent on the previous month, GlobalData found.

“Despite the economic volatility, Indian start-ups fractionally managed to gain investors’ confidence,” says Aurojyoti Bose, lead analyst at GlobalData.

“As the cyclical phenomenon of the funding winter suggests, India witnessed a slight month-on-month improvement in VC fund-raising in August.”

While it has been a difficult year for Indian start-ups, Bidhan Chowdhury, founder of tech platform TaCa Healthcare, hopes it will not deter entrepreneurs from coming up with solutions to tackle problems that India faces as a developing country.

“Start-ups have to focus on monetisation from the beginning itself,” he says.

“But I feel start-ups in a developing nation like India should get financial support more on the basis of their ability to bring about a change in the lives of people, rather than their ability to quickly scale up and make revenue.”

Mr Maitra prefers to consider the current environment as a “funding spring” rather than winter and believes that India's start-up ecosystem will benefit from the correction.

“I think investors are willing to back founders who are conservative, sensible and not burning cash for the sake of burning cash,” he says.

“I believe that far more healthier companies will come out of this slowdown than would have come out of the 2021 funding boom.”